Even Long-Term Investors Need to Understand High-Frequency Trading

[1]A new stock exchange called the IEX just launched last week[2] to protect the average investor from high-frequency traders. Should you be worried about whether you’re at risk?

What Is High-Frequency Trading?

The first thing to understand is that there are two sides of every stock trade — a buyer and a seller. Stock prices are determined by many factors, but it boils down to what price the buyer is willing to pay and what price the seller will accept. In the past, market makers[3] at brokerage firms would manually perform these transactions, but now it’s all automated. Market makers are still in the game, but after the crash of Lehman Brothers in 2008, stock exchanges started offering incentives for high-frequency traders to provide additional liquidity[4] to the markets with their super-fast trades.

High-frequency traders use advanced computer algorithms to put in large numbers of buy and sell orders at a rate that no human could ever match, and they move in and out of trades within milliseconds. That speed, and the sheer volume of trades they make, allow high-frequency traders to profit from very small moves in the stock — think Office Space, when disgruntled employees shave fractions of a cent from their company’s transactions so it can build up in their own accounts. Normally a fraction of a percent gain or loss on a trade doesn’t make much difference, but after millions of such trades, it adds up.

High-frequency trading is not accessible to small-time investors because of how much money it takes for a 0.001% gain to generate any significant profit. Those high-speed computer algorithms don’t come cheap, either.

Both Short- and Long-Term Investors Affected

The technology gap between professional high-frequency traders and regular people means that the days of making a living by daytrading are pretty much gone — not to say it isn’t possible[5], but the cards are stacked against the little guy trying to trade the news or technical patterns[6] in the short-term.

For long-term investors, the difference between buying Microsoft (MSFT[7]) at $35.50 versus $35.51 isn’t terribly significant. But even if you’re pretty hands-off with your investments, letting your 401(k) manager buy whatever funds you specify, high-frequency trading can still throw a wrench into getting your order fulfilled.

Back to the IEX

The institutional investors managing the investments in 401(k) accounts and pensions are dealing with a large number of shares, and to execute their orders, they go head-to-head with high frequency traders’ software on the “dark pool” markets, which are not accessible to small-time investors. Often, their orders are blocked because the prices move faster than institutional investors’ technology can keep up with, and they have to fulfill the buy orders in batches, at different prices. Or, predatory high-frequency traders can artificially manipulate prices on the dark-pool exchanges. So even if you and your coworker in the cubicle next to you have the same fund in your company 401(k)s, your performance might be slightly different based on the buy price the 401(k) manager was able to get.

The new IEX exchange is designed to level the playing field by staggering buy orders in a way that should thwart high-frequency traders from blocking them. It faces an uphill battle as the newcomer in the landscape of many other dark-pool exchanges, but as IEX chief executive Brad Katsuyama says, “If [institutional investors] make a decision to take ownership of their order, it will work.”

Should You Care About High-Frequency Trading?

At the end of the day, it comes down to the difference of a few cents. Over the long term, that won’t make a difference in your returns.

But if you have dreams of turning $500 into $5 million by daytrading, you should be aware that if the system puts institutional investors managing millions of dollars at a disadvantage, you’re not likely to fare any better.

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As of this writing, Carla Lake did not hold a position in any of the aforementioned securities.

Endnotes:

[Image]: http://investorplace.com/hot-topics/young-investors-series/

just launched last week: http://qz.com/138388/how-the-navy-seals-of-trading-are-taking-on-wall-streets-predatory-robots/

market makers: http://www.investopedia.com/terms/m/marketmaker.asp

liquidity: http://www.investopedia.com/terms/l/liquidity.asp

not to say it isn’t possible: http://investorplace.com/2013/08/is-day-trading-really-for-suckers/